client meeting

This article looks at the enhanced know-your-client (KYC) requirements of the client-focused reforms. It’s the second in my series that explores aspects of the reforms that will have the greatest impact on advisors. Here are some of the enhanced KYC requirements that you can start implementing now.

Meaningful interactions

You’re already collecting detailed information about a client’s goals, personal and financial circumstances, and willingness and ability to accept risk. The new requirements clarify that KYC collection should be a meaningful interaction with clients, instead of just an administrative process, as some have tended to treat it in the past. While the rules set out that a KYC update is required at least every three years, many firms are encouraging their advisors to conduct more frequent review conversations with clients, often on an annual basis. That annual review conversation is also an opportunity for you to deepen client relationships and identify ways to meet clients’ changing needs.

Updating KYC for a significant change in circumstances

The reforms also set the expectation that advisors make a reasonable effort to keep a client’s KYC information current. Of course, if there has been a significant change to a client’s KYC information, this may affect the suitability of their investments. An address change will not necessitate a KYC update, but life changes such as having children, marriage or divorce, or a significant increase (or decrease) in net worth or income will point to the need for a KYC update, as these changes may impact a client’s investment objectives or risk tolerance. The annual review conversation is a great way to determine if something major has happened in a client’s life.

Formalized risk profile for clients

The reforms require advisors to ensure they have “sufficient information” around a client’s risk profile to enable them to make a suitability determination. The reforms formalize the concept of a “risk profile” and clarify that this includes a determination of a client’s risk capacity, as well as risk tolerance. They specify that the process for developing a client’s risk profile should be “supportable and reliable”; they specifically refer to using tools such as questionnaires, which much of the industry already uses.

Risk capacity is a measure of a client’s ability to endure potential financial loss. There are a number of objective factors that must be considered around a client’s financial circumstances, but a client’s age and life stage can also be important considerations.

Risk tolerance is a personal measure of how much risk a client is comfortable taking or the degree of risk they’re willing to accept. For example, would they be able to sleep at night if they had a significant drop in their portfolio?

Risk capacity and risk tolerance work together to determine the client’s overall risk profile. A client’s risk profile should reflect the lower of their risk tolerance and risk capacity. Where a client’s return expectations conflict with the level of risk that they are willing and able to accept, the reforms clarify that simply investing them in higher-risk, unsuitable products is not acceptable.

Instead, you’re encouraged to have a further conversation with the client to clarify the relationship between risk and return, and realign their expectations. The regulators state that they do not want advisors overriding the risk a client is willing and able to accept in order to meet higher return expectations. If a client’s goals or return objectives can’t be achieved without taking greater risk than their risk profile dictates, advisors should outline alternatives, such as saving more, spending less, or retiring later.

New processes for client interactions

Many firms are building the new KYC requirements into their process or are creating new processes to capture the additional client data that’s required. I encourage you to see this as an opportunity to gain a better understanding of clients, rather than just another administrative step on an already busy day. Any tool or process that your firm puts in place should serve as a guide for a more in-depth conversation and will make it easier to collect the new information, and demonstrate that you have done so.

We know from numerous research studies that clients appreciate when you ask not only about their finances, but also about their hopes, dreams and personal situations. These types of quality conversations help them articulate their goals, which is key to a successful relationship and to demonstrating the value you provide.

Key KYC considerations for advisors

  • As of December 31, 2021, you’ll need to start collecting information to establish a client’s risk profile to include risk tolerance and risk capacity, and keep it current enough to support the enhanced suitability obligations. Ask your firm how they will assist you in doing this.
  • Start collecting the new KYC information to prepare yourself and clients for these changes. It will give you a head start on ensuring that KYC documents include an accurate reflection of a client’s risk tolerance and capacity, and that their portfolio is suitable.
  • The KYC process is supposed to be a meaningful interaction with clients. Use it as an opportunity to build rapport and truly add value by understanding their needs and helping them articulate their goals.
  • Plan to do annual review meetings with clients as a new best practice to not only keep KYC information current, but also to be aware of any significant changes to support a suitability determination.
  • In this age of privacy, it’s important to reassure clients why you need to ask these additional questions. Explain to clients that this enhanced process helps you better recommend what’s appropriate for them.